The Shanghai Stock Exchange fell 8.5% last Monday, then rebounded later in the week. Despite this, the Chinese authorities are supporting the market, which in turn has caused much free market tut-tutting from Western analysts.

But given the fragile nature of the Shanghai market and the inexperience of Chinese retail investors, the authorities can’t afford to take a purist free market approach. Still, there may be a policy solution to their problem.

You see, the run-up in Chinese stocks to its peak in June 2015 had been ebullient.

A Washington Post story on the Shanghai market had some fun examples of excess. Like how a Chinese real estate company had changed its name to P2P Financial Services Co. without bothering to develop a peer-to-peer lending business, yet saw its stock jump 10%.

The Post’s story also pointed out that Chinese stock markets rose enough during the year to create $6.5 trillion of value! That’s about 70% of China’s 2013 GDP and 40% of the New York Stock Exchange’s value.

But, long term, the Shanghai market doesn’t look overvalued.

Seeing What’s Actually There

The market is now a third below its all-time high, reached in 2007. It’s 5.5 times the level it was 20 years ago, at the beginning of August 1995. That sounds like a lot, until you remember that the Chinese GDP in 2014 was 10.2 times the level it was in 1995 in renminbi terms, or 14.5 times its 1995 level in dollar terms.

Thus, since 1995, the Chinese stock market has risen only half as much as the nominal GDP. For comparison, the U.S. stock market, which is standing at 4.5 times its early 1995 level, has risen more than twice as much as the nominal GDP since 1995.

You also have to remember that Chinese savings are much higher than those in the United States (and that there are four times as many Chinese as Americans). Chinese households save more than 20% of the GDP, about $2 trillion in 2015. By comparison, U.S. household savings, at 5.5% of the GDP, are less than $1 trillion. As Chinese savers have reoriented from housing to the stock market, it’s not surprising they’ve caused a boom.

As is often the case, the cause of the speculation was excess money supply. Chinese monetary policy and bank lending policies have been excessively lax in recent years, causing a massive run-up in real estate that’s left a bad overhang and led foolish retail investors into buying stocks on margin.

Perceived Problems

So, the Chinese government now has a problem.

If they allow the market to crash uncontrollably, as it was doing when it dropped 32% in a month, the damage to foolish retail investors, their lenders, and the Chinese economy in general could’ve been incalculable. Hence it leaned on the banks to prop up the market, devoting as much as $200 billion to this effort and stabilizing the rout. On July 4, the largest state-owned brokerages appeared to establish a level of 4,500 on the Shanghai Composite – still 15% above the current level – as a price target.

This is unusual, but not unprecedented, behavior. The Hong Kong Government propped up that market when it crashed in 1998 and 1999. It’s really no different from the Fed pumping money into banks to prop up housing, it’s just a different asset.

And there’s no reason why it shouldn’t work. The Fed’s easy money policies have succeeded in propping up the U.S. housing market, whatever other damage they may have done, and the Chinese stock market doesn’t appear overvalued.

Searching for Solutions

For the Chinese government, the best solution may not lie in the domestic market at all. For many years, Chinese shares have been dual-listed on Hong Kong, trading there as “H” shares, generally at significantly lower valuations than in the domestic market. Since Chinese retail investors are still limited in their ownership of offshore assets, the two markets can coexist without much arbitrage between them.

Now, MSCI Barra, the international index provider, has indicated that it’s considering including the Shanghai market in its international and emerging market indexes, but drew back in June because of the restrictions against foreigners investing in that market and domestic investors investing outside it.

Therefore, all China has to do is relax exchange controls. To the extent its domestic citizens want to own assets offshore, they will then move their money – weakening the renminbi somewhat, but probably expanding Chinese exports and helping the economy. More important, the “H” share market in Hong Kong and the “A” share market in Shanghai will effectively merge. While this may exert a short-term downward pressure on Shanghai prices, the larger universe of investors buying in Hong Kong and the greater liquidity between the two markets will support prices overall and reduce the risk of a catastrophic price fall.

An exchange control liberation will probably lead MSCI to include China in its international indexes, with an initially small weighting that will increase over time to reflect China’s massive weight in the global economy. That will bring a wall of money from international indexed and quasi-indexed funds into the Shanghai market. The result should be a boom such as you’ve never seen before.

As I said, Chinese shares are not overvalued. If you want to buy, I suggest the iShares China Large-Cap ETF (FXI) and the Guggenheim China Small Cap ETF (HAO). Both invest in indexes of Chinese shares trading on Hong Kong, and so would benefit from any unification of the Hong Kong and Shanghai markets.

Good investing,

Martin Hutchinson

For 27 years, Martin Hutchinson was an international merchant banker in London, New York, and Zagreb. He ran derivatives platforms for two European banks before serving as director of a Spanish venture capital company, advisor to the Korean company Sunkyong, and chairman of a U.S. modular building company. Learn More >>

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